PRECAUTIONARY SAVINGS AND THE PERMANENT INCOME HYPOTHESIS

This paper derives the explicit solution of a dynamic stochastic optim al consumption problem for infinitely-lived agents whose preferences e xhibit, in the presence of non-diversifiable labour income uncertainty , a constant elasticity of intertemporal substitution and constant abs olute risk aversion. The constancy of the elasticity of intertemporal substitution, which implies that marginal utility at zero consumption is infinite, guarantees that the non-negativity constraint on consumpt ion is never binding along the optimal path. The assumption of constan t absolute risk aversion allows an explicit computation of human wealt h, and provides a simple representation of the precautionary savings m otive.